Obsolete Inventory Write-Off: Journal Entry for Small Sellers

Can I write off dead or obsolete inventory, or write it down to zero?

For a seller that keeps an inventory, dead stock is deducted when it leaves the year-end count, not when you decide it is worthless. Stock still on your shelves stays at cost, with two exceptions, and on the usual cost methods a reserve in your books is not a deduction.

If you expense purchases and keep no formal inventory, read the section on expensing purchases below first.

Dead stock reaches your return in three ways:

• Gone from the count. Sold, thrown away, destroyed or lost. Cost of goods sold is opening inventory plus purchases and other costs, minus closing inventory, so goods missing from the closing count raise it (Schedule C, Part III).
• Still on hand and unsalable at normal prices. Valued at the price you actually offer them for, minus the direct cost of selling or disposing of them, if the offering period ends no later than 30 days after the inventory date, usually the year-end count date (26 CFR 1.471-2(c)).
• Still on hand, and you use lower of cost or market. Each item is valued at the lower of cost or market, which is the current price to buy or make it again on the count date (26 CFR 1.471-4; Publication 538).

Under the cost and lower of cost or market methods, the regulations reject a reserve for price changes or an estimated drop in value (26 CFR 1.471-2(f)).

A case is not simple if the stock is large or old, was never counted, or sits under a method you cannot name; if an earlier return already took a write-off, especially without count sheets or offers; if the IRS has written to you about inventory; or if a corporation's or partnership's books show a bigger write-down than the return can. There the facts decide the amount, not a formula.

Gather first: dated count sheets with unit costs and supplier invoices; every mark-down offer and the sales after year-end; proof of disposal, or the charity's receipt for a gift.

What counts as dead, obsolete or excess stock?

Tax rules have no category called dead or obsolete stock. The closest is goods unsalable at normal prices or unusable in the normal way because of damage, imperfections, shop wear, changes of style, odd or broken lots or similar causes, which Form 1125-A calls subnormal goods (26 CFR 1.471-2(c); Form 1125-A).

Slow-selling stock is not on that list. Whether it qualifies as a similar cause depends on the facts, and the seller has the burden of proof.

The test is an actual offering. A bona fide selling price means an actual offering of the goods during a period ending no later than 30 days after the inventory date. For a December 31 inventory date, the offering period must end by January 30; an offer that starts before year-end can qualify. Goods kept at the normal price have no lower offered price to value them at.

Raw materials and partly finished goods held for use, such as a craft seller's supplies, get a reasonable value based on condition and usability, never below scrap value.

Which inventory method am I on, and does it change the write-off?

The method on your return decides whether stock can be marked down before it leaves. Check Schedule C, line 33, or Form 1125-A, line 9a. Schedule C has no box for the small business methods; Form 1125-A does, on lines 9a(iv) to 9a(vi).

A small business taxpayer is a seller, not a tax shelter, with average annual gross receipts of $32,000,000 or less over the three prior tax years, with related businesses combined, and an individual's receipts from all their businesses and shares of partnership and S corporation receipts counted together (26 CFR 1.471-1(b)(2)). It may choose not to keep an inventory (Publication 538).

A valuation method is a method of accounting, and changing one takes IRS consent on Form 3115 (Instructions for Form 3115). To choose between inventory and supplies, see inventory or supplies for small sellers.

What is the journal entry for an obsolete inventory write-off?

A write-off lowers the inventory account and, except for a donation or a book-only reserve, raises cost of goods sold. A write-down lowers the value of stock you still hold; a write-off removes it. Use the amount still carried in Inventory after earlier write-downs: a later discard, sale or gift removes only that remaining value. No government page prescribes journal entries, so these are standard bookkeeping practice.

Under the cost and lower of cost or market methods, a reserve stays in the books only: the return uses the count. On the small business methods that follow the books or a financial statement, the regulation does not say whether a book reserve carries to the return, so confirm that before deducting one. Date the year-end valuation entry at the count date, from the count sheet; record sales, gifts and disposals on their own dates, even if a later sale supports the year-end value. The count sets the closing figure, and the book balance is adjusted to match it (Publication 538). If your books write stock down further than the rules above allow, keep the difference in a note for your preparer.

How does a write-off show on Schedule C Part III or the business return?

If you keep an inventory, a write-off shows as a lower closing inventory, which raises cost of goods sold. There is no separate write-off line.

• Schedule C (sole proprietor or single-member LLC). In Part III, line 41 is the lower year-end figure, and line 42, cost of goods sold, carries to line 4. Line 33 names the valuation method. Line 34 asks whether anything changed in determining quantities, costs or valuations between opening and closing inventory; if your write-down changed how you value or count stock, answer Yes and attach an explanation (Schedule C; instructions).
• Partnership, S corporation or C corporation. On Form 1125-A, line 7 is closing inventory and line 8, cost of goods sold, goes to page 1, line 2 of the return. Check line 9b if there was a writedown of subnormal goods. Boxes 9a(iv) to 9a(vi) are for small business methods. Line 9f asks about changes in quantities, cost or valuations (Form 1125-A).

For the full Part III walk-through, see cost of goods sold on Schedule C.

How do I get rid of obsolete inventory: throw it out, sell it cheap or donate it?

If you keep an inventory, each route reaches the return differently, and a gift can deduct less than the goods cost.

Under the general rule, goods bought and given away in the same year have no basis for a charitable deduction; their cost stays in cost of goods sold (Publication 526). Qualifying food gifts, and certain gifts by C corporations for the care of the ill, the needy or infants, follow special deduction and cost rules (26 U.S.C. 170(e)(3)). A sole proprietor deducts a gift on Schedule A, only if itemizing, and not on Schedule C (Publication 526; Instructions for Schedule C). For the floor on an individual's itemized gifts, how a partnership or S corporation passes a gift to its owners, and a C corporation's limits, see charitable donations from the business.

What proof does the IRS want?

For goods valued at an offered price, the seller carries the burden of proof and must keep records of what happened to the goods, so the inventory can be verified (26 CFR 1.471-2(c)). Inventories should be recorded legibly, summarized, and kept with the accounting records (26 CFR 1.471-2(e)).

The IRS lists no required format. These records answer the questions the regulation asks:

Keep records for as long as they may be needed, which generally means until the period of limitations for that return runs out (Publication 583). The books must include inventories sufficient to establish deductions (26 CFR 1.6001-1(a)).

I expense my purchases and never kept an inventory: is there anything to write off?

It depends on the method, and deducting purchases when you pay for them is not always allowed.

• Books-and-records method. A seller on this method whose books deduct purchases when paid has already deducted the cost, and writing the stock off again would deduct it twice. The method needs books that properly reflect the business for non-tax purposes. The regulation's own example says a seller that expenses every purchase in its ledger, while staff count stock and give a lender inventory cost figures, may not expense everything and must use the physical count (26 CFR 1.471-1(b)(6)).
• Materials and supplies method. Cost is recovered when goods go to a customer, or when the cost is paid or incurred, if later (26 CFR 1.471-1(b)(4)), so the cost of unsold dead stock is not yet deducted. The regulation does not say what happens to goods thrown away unsold, so have your preparer confirm the year the cost is deductible before you book the write-off.
• Neither. A seller above the receipts limit, or one that never chose a method, may need an inventory. If past returns show none, see inventory missing from past returns.

Is stock lost to theft, damage or a disaster the same thing?

Partly. Lost stock leaves the count like any other, but theft, casualty and disaster have their own proof and a second way to claim.

• Two ways to claim. Report opening and closing inventory correctly, so the loss runs through cost of goods sold; insurance or other reimbursement is then income, and you do not claim the loss again. Or claim it separately, adjust opening inventory or purchases so it is not counted twice, and reduce the loss by the reimbursement received or expected (Publication 538; Publication 547).
• Disaster. A loss tied to a federally declared disaster can be claimed on the preceding year's original or amended return by election, due six months after the disaster year's regular return due date, ignoring extensions. The same loss cannot also be deducted for the disaster year, including through cost of goods sold, so adjust that year's inventory (26 CFR 1.165-11; Publication 547).
• Proof of theft or casualty. Show that you owned the goods and whether a reimbursement claim exists. For a theft, show that the goods were stolen and when you discovered the loss. For a casualty, show the type of event, when it happened and that the loss was a direct result. The simple disappearance of property is not a theft, though goods that went missing are still absent from the count (Publication 547).
• Slow damage. Damage from a steadily operating cause, such as a long-running leak, is progressive deterioration, not a casualty. The goods may still be subnormal goods.

For marketplace warehouse fees, lost units and reimbursements, see marketplace fees and inventory.

I wrote stock off in past years without proof: how do I fix it?

Sort what was deducted first, because the kind of deduction decides the route.

1. List each year's write-off: the amount, why it was taken (a reserve, a mark-down with no offering, goods discarded) and which records still exist.
2. A reserve, or a mark-down that fits neither the 30-day rule nor lower of cost or market, is not accepted under the cost methods (26 CFR 1.471-2).
3. A change in how inventories are valued is a change in method of accounting, and in most instances a method is not established without consistent treatment (26 CFR 1.446-1(e)). The same treatment on two or more consecutively filed returns counts as consistent (Rev. Proc. 2015-13, section 2.01), and changing an established method takes Form 3115 (Instructions for Form 3115).
4. If you have a notice, are under examination, or took the write-off in several years, settle the route with a preparer before amending anything. For the choice between amending and Form 3115, see inventory missing from past returns.

Missing records can often be rebuilt in part; see cost of goods sold with no records.

Example

All figures are illustrative, in US dollars.

A boutique clears last season's clothing

A boutique on the cost method counts $9,000 of last season's clothing, which qualifies as a change of style, at cost on December 31. The goods usually sell for $12,000. On January 10 it offers them at half price, $6,000, and expects $500 of direct selling costs. It keeps the dated price list, the January sales and the count sheet.

• Value of the goods: $6,000 minus $500 is $5,500. Closing inventory falls by $3,500, and cost of goods sold rises by $3,500.
• Entry: debit inventory write-down (cost of goods sold) $3,500; credit inventory $3,500.
• The $5,500 is next year's opening inventory; a lower value at the next count needs a new offering ending within 30 days after that count.
• Had it left the tags at full price, there would be no offered price to value the goods at, so they would stay at $9,000.

An online seller discards broken goods

An online seller values stock at cost and finds $1,200 of broken goods during the December count. She photographs them, throws them away and drops them from the count.

• Closing inventory falls by $1,200, and cost of goods sold rises by $1,200.
• Entry: debit inventory write-off (cost of goods sold) $1,200; credit inventory $1,200.
• Records that support it: the photos and a dated note listing items, quantities and unit costs.

A craft seller donates unsold items

A craft seller gives a charity items that cost $2,000 and sat in her opening inventory. In her usual market they would sell for $500.

• The charitable deduction is the smaller of value or cost, $500, claimed on Schedule A if she itemizes, subject to the floor on an individual's itemized gifts.
• The regulation takes the full $2,000 cost out of opening inventory, while Publication 526 takes out only the deduction, so the other $1,500 of cost is treated differently. A preparer should settle which applies before filing.

Different for you?

• Your stock is large or old, was never counted, an earlier return took a write-off, books and return differ, the IRS has written to you about inventory, or you expense purchases and cannot tell what is left to deduct: which method you are on, what loss this year's records support, how to book it and whether earlier years need fixing are judgment calls. Work them out with bookkeeping help.
• Servers, GPUs and hardware parts, or reserves in depth: writing off unsold or obsolete inventory.
• Donating stock, the floor on itemized gifts, or a corporation's donation limits: charitable donations from the business.
• You need to count or value stock, or find where cost of goods sold goes: cost of goods sold on Schedule C.
• You are choosing between inventory and supplies, or switching methods: inventory or supplies for small sellers.
• Past returns showed no inventory: fixing inventory missing from past returns.
• It is year-end and the count is still open: year-end close checklist.
• Your state taxes inventory or income differently: this page covers federal income tax; ask your preparer about your state.